No Signs of Stock Froth in the Tea Leaves

The big question on investors’ minds now is a simple, if scary, one: Is the stock market topping out?

After surging 32% last year, including dividends, the S&P 500 index has bogged down in 2014. It closed at a record 1859.45 Friday, but that is up just 0.6% from Dec. 31. The Dow Jones Industrial Average closed at 16321.71 Friday, still down 1.5% from Dec. 31.

Just to be safe, some professional money managers are lightening up on stocks, traders say. But analysts who track investor psychology and trading patterns say it could be too soon to head for the exits.

Many expect stocks to be volatile and some predict a sharp pullback in 2014. Just not yet. Investors simply aren’t acting the way they typically do when stocks are on the brink of serious trouble, these analysts say.

“There’s nothing that I see here now that says imminent demise,” said Phil Roth, a veteran independent analyst who correctly predicted the end of the previous bull market in 2007.

True, Mr. Roth says, the current bull market has been running for nearly five years and is weary. Based on corporate earnings levels, stocks are probably overpriced. A negative event, such as trouble in the bond market or in the world economy, could send stocks down.

But otherwise, Mr. Roth says, the market backdrop doesn’t yet look the way it has before previous big declines.

“Most tops are made with rising interest rates, rising inflation and rising stock prices,” he said. They often come when stock-investor optimism is over the top, making people ignore warning signs and buy heavily even as the Federal Reserve tries to cool things off by pushing interest rates higher.

That isn’t the way the market looks today. Inflation isn’t a problem, market interest rates as reflected in bond yields have been remarkably contained, and stock prices haven’t been hot since the end of last year.

To determine when investor spirits are excessive, analysts watch a variety of arcane indicators. These include surveys of professional and amateur investors and gauges of how investors use options to hedge investments.

“We aren’t seeing any consistent signs of extremes in sentiment,” said Will Geisdorf, global strategist at Ned Davis Research Inc. in Venice, Fla.

Optimism was over the top late last year as stocks were hitting records, he says. But the excitement faded in 2014 and stocks pulled back. He called the emotions of late 2013 a “first glimpse of excessive optimism.” Before stocks take a real tumble, he said, that kind of excess probably will return for a longer spell.

Mr. Geisdorf and his colleagues still expect a decline of 10%, 15% or more this year, especially if stocks turn in bigger gains and investor euphoria kicks in. But “we really think it is a little early at this point,” he said.

As an example, he and Mr. Roth both point to a widely followed survey of newsletter writers, compiled by a firm called Investors Intelligence. More than 60% of stock newsletters were bullish as January began, Mr. Geisdorf says, an unusually high percentage.

That suggested the optimism was overdone and indeed, stocks pulled back to start the year. But as stocks slumped in January, the percentage of bullish newsletter writers fell to 42%. Now it is 53%. For him to worry, indicators like that would have to get back to an extreme level and stay there for a while, Mr. Geisdorf says.

Mr. Geisdorf also watches consumer-confidence levels, which can parallel investor confidence. While consumer confidence has recovered, it isn’t off the charts, he says.

Many analysts also watch options trading, because sophisticated investors use options to guard against market declines. They buy “put” options permitting them to sell at a preset price in case stocks fall. When optimism is excessive, investors stop bothering with puts, so a big drop in demand for puts is a sign of excessive optimism.

Right now, option demand is about average, Mr. Roth says, far from the danger zone.

Another indicator he looks at is a poll of stock-index futures traders. It surpassed 76% bulls in December, a worrisome level. Today it is back to 63%. That still is above the 10-year average of 55%, but the sharp pullback since December suggests to Mr. Roth that, here as well, optimism isn’t excessive.

Paul Hickey, co-founder of Bespoke Investment Group in Harrison, N.Y., points to a survey by the American Association of Individual Investors, which tracks member bullishness. Bullishness ran around 40% last year, compared with a historical average of 39%, Mr. Hickey says. No overheating there.

And the Conference Board’s February consumer survey included a question about stocks; more people expected declines than gains, Mr. Hickey says.

“Right now we are not at an extreme in one direction or another,” Mr. Hickey concludes.

An external shock could still jolt the market and send stocks down. And there is no guarantee that stocks will rise much from here. What these analysts are saying, however, is that the market isn’t showing the classic signs of excess that you often see before a serious drop.